The SEC Bans All Naked Short Selling

The SEC announced today that they took "coordinated actions to strengthen investor protections" against naked short-selling. These new regulations (well, not really new) will apply to the securities of all public companies, and will go into effect on Thursday, September 18th.

First off - what is naked short-selling?

In a typical (and legal) short sale, a short-seller will borrow or ensure that the shares of a stock can be borrowed. Then, they will sell the shares that they have borrowed, hoping to buy them back at a lower price. For instance, let's say that someone believes that the price of GE will drop over the next week, and they want to profit from this theory. They will have their broker "locate" shares to borrow, and then sell shares of GE without ever having owned them. So if they sell the shares at $20 and buy them back at $16 a week later, then the short-seller will pocket the $4 difference in profit and return the borrowed shares to the original owner, without the owner being none the wiser.

In a naked short sale, the short-seller sells the shares without having borrowed them or ensured that they were available to borrow. The shares are not given to the buyer, and the trade is considered to have "Failed to Deliver".

Here are the steps that the SEC announced that they will be taking today:

1. Hard T+3 Close-Out Requirement; Penalties for Violation Include Prohibition of Further Short Sales, Mandatory Pre-Borrow

Naked short selling is not to be confused with regular short selling. Some people are of the opinion that all short-selling will be illegal under these new rules, or that short-selling itself is a bad thing. It's not. It's a perfectly legitimate trading strategy. Short-sellers can be a fountain of useful information and help to counteract the steady barrage of bullish opinions that we hear from analysts and market pundits. Legitimate short-sellers were amongst the first to identify such problem companies as Enron, Fannie Mae and Freddie Mac.

Also, short-selling is being unfairly portrayed by some in the media as the reason why the stock market has been dropping off so suddenly as of late. It's not, and barring naked short-selling won't be a magical bullet that will slay all of the bears that are currently feeding on the markets.